By BRENT SHEATHER
The word "risk" means different things to different people, as last week's Weekend Money pointed out.
Analysts tell us the way to measure the riskiness of an investment portfolio is by looking at how variable its returns are.
This is great in theory, but statistical formulae aren't much use to the average person - most of us haven't the time or inclination to calculate volatility.
Perhaps the best way for the do-it-yourself investor to assess the risk level of his or her portfolio is to focus on the issue that has the biggest impact on risk.
That something is asset allocation - the proportion of your money that you have in the various classes of investment - fixed interest, property and shares.
All things being equal, the more you have in shares and the less in fixed interest, the riskier your portfolio will be. That's basic, but what's not so basic is trying to work out an "average" risk level, so you can see how your investments compare.
One way is to have a look at how the big players - the professional fund managers - divide up their portfolios. This is a heck of a lot more fun than calculating your portfolio's standard deviation, believe me.
Because we can work out how the average pension fund invests, we can compare our own asset allocation with something which represents the consensus view of a great many New Zealand experts and thus see whether our portfolios are higher or lower risk.
Every three months the Aon Consulting group publishes details of the asset allocations of most of the big fund managers in the local superannuation and savings field, from which we can calculate a simple average asset allocation.
That average - as at March 31 - is illustrated in the pie-chart.
This information is particularly useful because the fund managers' allocations have been consistent for the past 10 years or so, bouncing around 40 per cent bonds, 10 per cent property and 50 per cent shares.
In the past few years, local managers have been busy switching their shares and bonds from New Zealand to overseas but that 40/10/50 split has remained fairly constant. So we can define that as an average risk portfolio.
But what about the average investors who manage their own savings, perhaps with the help of a stockbroker or financial planner? What do their portfolios look like?
These people typically make their own choices, and asset allocation often just happens as a consequence of many smaller, separate decisions. While New Zealanders may not be good savers as a rule, anecdotal evidence suggests that - of those people who do own shares - many have relatively high weightings.
In the course of my work I often come across otherwise rational people with upwards of 70 to 80 per cent of their investments in shares. Several factors have combined to bring this about:
* Taxation: Many New Zealanders have a pathological fear of paying too much tax. Because we don't have a capital gains tax, except for professional investors and traders, if you want to avoid tax on your investment returns, all you have to do is buy shares. In many cases even the dividends will be tax-free.
* Historic returns: Despite our own moribund market, the cult of equity is firmly embedded in New Zealand. The great 20-year international bull market and the falling kiwi dollar have made a lot of New Zealanders wealthy and biased their portfolios accordingly. As well, high inflation badly affected Government bond portfolios in the 1970s and 80s while shares provided a good defence against rising prices.
Bias:The intermediaries who assist private investors - financial planners and stockbrokers - are paid by fees and commissions, and more often than not these fees are higher for share-based investments than they are for fixed interest.
In some cases the fees are so high they would be unsustainable with anything less than the high returns potentially available from shares.
If shares have been such a great long-term investment, why bother with bonds at all?
True enough, shares have been great, particularly in the past 20 years, but warning signs suggest the golden age of equities may be drawing to a close. More ominously, some very large professional investors have started to increase the proportion of their portfolios in bonds.
Some of the more vocal proponents of increased fixed interest investment have been the financial market historians at Barclays Capital in London.
Every year since 1956, Barclays Capital has published a study giving data and analysis of the annual returns from bonds, cash and shares in Britain and the United States since 1899.
The February 2001 issue of that study suggests that British pension funds are beginning to shift from shares to bonds and cites demographic trends which suggest that increasingly investors will be looking for income as opposed to capital growth.
Because the trends are for a large increase in the number of retirees, as opposed to contributors to pension funds, the implication is that portfolios will need more bonds to provide this income.
The same demographic trends can be seen through most of the western world, including New Zealand.
That means demand for fixed-interest investments is likely to increase. At the same time, supply is likely to be limited.
Barclays Capital sees companies in the future increasingly financing their balance sheets with equity - issuing shares - rather than debt.
Reinforcing this trend is the fact that with low inflation, the prices of bonds and shares tend to move in opposite directions, making the addition of bonds to a portfolio especially attractive as a way of reducing volatility.
Another warning sign which should perhaps temper our enthusiasm for shares is the low dividend yield they now provide.
Economics tells us that in the long run, the return on shares should be equal to the dividend yield plus economic growth.
The Barclays study says dividends from the US and British sharemarkets (about 65 per cent of all the world's sharemarkets) are close to all-time lows, after declining more or less constantly since the mid-1980s.
Twenty years ago average dividend yield of shares in the US S&P 500 index was 5.2 per cent; today it is about 1.3 per cent. Lower dividends imply lower total returns.
As well as having a good mix of investment classes, the other big way of minimising risk is ensuring that your portfolio is properly diversified within each category. It's no use having 50 per cent of your investments in shares, for example, if you own shares in only one company.
Some new research shows that the recent increase in the volatility of individual shares means that, while 20 shares would have done the job 15 years ago, one now needs 50 shares to achieve the same degree of diversification.
What this means is that next to no one can afford to own individual stocks - managed funds are compulsory for anyone who takes risk management seriously.
One of the best reasons for getting your risk profile right is to ensure that when the inevitable meltdown occurs, you don't have such a high proportion of your investments in shares that you feel under pressure to sell, usually at the very worst time.
This is a behavioural response to risk which can't be modelled on a computer or seen on a graph of historic returns, but it is a very real condition here and overseas, as many studies shows.
Look at the graph above and ask what you would have done with your shares in August 1932. How would you explain to your husband or wife that your $100,000 in shares was now worth only $10,000?
If you bought into the US market in August 1929 it would have taken about 25 years before the capital value was back to square one. Now that's a bear market.
Individuals with high weightings in shares and low weightings in bonds should not panic but address the imbalance over time. But as one pundit put it, if you must panic, panic before everyone else does.
* Brent Sheather is a Whakatane sharebroker and investment adviser.
Money: Watch and learn from the big players
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